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Earnings Per Share-Price Earnings Ratios-Book Value Per Share Using Accounting Information Financial Reporting and Concepts 2. Earnings per Share, Price Earnings Ratios, Book Value per Share, and Dividend Rates How is one to meaningfully compare the net income of a large corporation that has tens of millions of shares outstanding to smaller companies that may have less than even one million shares out? The larger company is probably expected to produce a greater amount of income. But, the smaller company might be doing better per unit of ownership. To adjust for differences in size, public companies must supplement their income reports with a number that represents earnings on a per share basis. Earnings per share, or EPS, is easily the most widely followed and best understood performance measure in corporate reporting. It represents the amount of net income for each share of common stock. Corporate communications and news stories will typically focus on the EPS results, but care should be taken in drawing any definitive conclusions based on a single calculated value. Remember, lots of nonrecurring transactions and events can positively or negatively impact income and EPS; always look beyond the headlines. Excellent Economics and Business programmes at: “The perfect start of a successful, international career.” CLICK HERE to discover why both socially and academically the University of Groningen is one of the best www.rug.nl/feb/education places for a student to be Download free eBooks at bookboon.com 16 Click on the ad to read more Using Accounting Information Financial Reporting and Concepts 2.1 Basic EPS Having now been introduced to EPS concepts, it is time to focus on the accounting calculation of this important number. Basic EPS may be thought of as a simple fraction with income in the numerator and the number of common shares in the denominator, as follows: Income/Number of Common Shares Outstanding Expanding this thought, consider that income is for a period of time (e.g., a quarter or year), and during that period of time, the number of shares might have increased or decreased because of share issuances and treasury stock transactions. Therefore, a more correct characterization of the Basic EPS calculation is: Income/Weighted-Average Number of Common Shares Outstanding Further, one must consider that some companies have both common and preferred shares. Remember that dividends on common and preferred stock are not expenses and do not reduce income. However, the preferred stock dividends do lay claim to some of the corporate income stream that would otherwise benefit common shares. Therefore, one more modification is needed to correctly portray the Basic EPS fraction: Basic EPS = Income Available to Common/ Weighted-Average Number of Common Shares Outstanding This last modification to the Basic EPS calculation entails a reduction of income by the amount of preferred dividends for the period. An illustration may help to clarify the calculation of Basic EPS. Assume that Kooyul Corporation began 20X4 with 1,000,000 shares of common stock outstanding. On April 1, 20X4, Kooyul issued 200,000 additional shares of common stock, and 120,000 shares of common stock were reacquired on November 1. Kooyul reported net income of $2,760,000 for the year ending December 31, 20X4. Kooyul also had 50,000 shares of preferred stock on which $500,000 in dividends were rightfully declared and paid during 20X4. Kooyul paid $270,000 in dividends to common shareholders. How much is Kooyul’s EPS? Income available to Kooyul’s common shareholders is $2,260,000. This amount is calculated as the net income ($2,760,000) minus the preferred dividends ($500,000). Dividends on common stock do not impact the EPS calculation. Weighted-average common shares outstanding during 20X4 are 1,130,000. The following table illustrates how this is calculated: Download free eBooks at bookboon.com 17 Using Accounting Information Financial Reporting and Concepts Weighted- Portion of Shares Outstanding Calculation Time Interval Average Year During Time Interval Impact Jan. 1 through 3 months 1,000,000 250,000 March 31 3/12 X 1,000,000 = * April 1 through 1,200,000 7 months 7/12 X 1,200,000 = 700,000 Oct. 31 (1,000,000 + 200,000) Nov. 1 through 1,080,000 2 months 2/12 X 1,080,000 = 180,000 Dec. 31 (1,200,000 - 120,000) 12 months 1,130,000 Therefore, Kooyul’s Basic EPS is $2 per share ($2,260,000/1,130,000). 2.2 Diluted EPS For many companies, the Basic EPS is all that is required to be presented. But, other companies must report an additional Diluted EPS number. The Diluted EPS is applicable to companies that have more complex capital structures. Examples include companies that have issued stock options and warrants that entitle their holders to buy additional shares of common stock from the company, and convertible bonds and preferred stocks that are potentially to be exchanged for common shares. These financial instruments represent the possibility that more shares of common stock will be issued and are said to be potentially “dilutive” to the existing common shareholders. Accounting rules dictate that companies with dilutive securities take the potential effect of dilution into consideration in calculating the auxiliary Diluted EPS number. When you see a company that discloses Diluted EPS, it means they have done a series of (rather complex) calculations based on assumptions that dilutive securities are converted into common stock. The hypothetical calculations are quite imaginative; even going so far as to provide guidelines about how money generated from assumed exercises of options and warrants is assumed to be “reinvested” by the company. There is plenty of room to quibble over the merits of the assumptions, but the key point is that Diluted EPS provides existing shareholders a measure of how the company’s income is potentially to be shared with other interests. Dilutive effects should never be ignored in investment decision-making! 2.3 Subdividing APS Amounts You now know that public companies are required to report EPS information, and you earlier learned that companies must present a fully developed income statement that segregates income from continuing operations from other components of income (e.g., discontinued operations, etc.). Putting these two facts together, you might assume that EPS information should parallel the detailed information shown on the income statement. And, that assumption is correct. Earnings per share information must be subdivided to reveal per share data about income from continuing operations, discontinued operations, extraordinary items, and net income. Download free eBooks at bookboon.com 18 Using Accounting Information Financial Reporting and Concepts 2.4 Price Earnings Ratio Financial analysts often incorporate reported EPS information into the calculation of a popular ratio -- the price/earnings ratio (P/E). This is simply the stock price per share divided by the EPS: Price Earnings Ratio = Market Price Per Share/Earnings Per Share For example, a stock selling at $15 per share with $1 of EPS would have a P/E of 15. Other companies may have a P/E of 5 or 25. Why would different companies have different P/E ratios? Wouldn’t investors always be drawn to companies that have the lowest ratios since they may represent the best earnings generation per dollar of required investment? The answers to these questions are complex. Remember that the “E” in P/E is past earnings and does not reflect the future. New companies may have a bright future, even if current earnings are not great; investors are sometimes willing to pay a premium. Other companies may have great current earnings, but no room to grow; investors will not pay as much for these. And, don’t forget that some companies hold valuable non-income producing assets; investors sometimes pay for such embedded values even if they are not presently generating an income stream. Suffice it to say, there are many reasons that P/E ratios differ among companies. LIGS University based in Hawaii, USA is currently enrolling in the Interactive Online BBA, MBA, MSc, DBA and PhD programs: ▶ enroll by October 31st, 2014 and ▶ save up to 11% on the tuition! ▶ pay in 10 installments / 2 years ▶ Interactive Online education ▶ visit www.ligsuniversity.com to find out more! Note: LIGS University is not accredited by any nationally recognized accrediting agency listed by the US Secretary of Education. More info here. Download free eBooks at bookboon.com 19 Click on the ad to read more Using Accounting Information Financial Reporting and Concepts A related ratio that is gaining popularity is the “PEG” ratio. This is the P/E ratio divided by the company’s “growth” rate. For example, a company with a P/E of 20 that is experiencing average annual increases in income of 20% would have a PEG of 1. If the same company instead had annual earnings increases of 10%, then the PEG would be 2. As a rule of thumb, the lower the PEG number, the more attractive the investment appears. Use this ratio with extreme care as growth rates are very susceptible to sudden changes; high growth rates are hard to sustain and many a high flying company has seen a sudden change in their fortune. 2.5 Book Value per Share Another per share amount that analysts frequently calculate from accounting information is the book value per share. The term “book value” is synonymous with the amount at which an item is reported on the balance sheet. For example, in the context of property, plant, and equipment, recall that it means the reported amount for a particular asset. However, in the context of the analysts’ “book value per share” number, it refers to the amount of reported stockholders’ equity for each share of common stock.
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